William G. Dewald, director of research for the St. Louis Fed, examines how inflation magnifies the distorting effects of taxation when the tax treatment of interest income and expense is not fully indexed to inflation. The distortion involves a real interest tax wedge which is the difference...

Inflation magnifies the distorting effect of taxes on the allocation of resources through the credit market. Distortions arise because of the difference between the after-tax real return to lenders and the real cost to borrowers. These distortions could be avoided by indexing to inflation the...